Why did Dollar General's profitability fall so sharply in fiscal 2006?

The decline came mainly from strategic initiatives launched in Q4 2006. The company discontinued its traditional packaway inventory model and sold through excess seasonal, home and apparel merchandise with heavy markdowns, totaling $279.1M at cost in 2006 versus $106.5M in 2005. It also recorded a $70.2M lower-of-cost-or-market inventory charge and SG&A charges tied to closing about 400 stores. Higher advertising, promotional spending, and executive compensation added to the pressure, partly offset by $13.0M of Hurricane Katrina insurance proceeds.

Is the margin pressure expected to be temporary?

Management says the markdown-driven pressure should persist through 2007, with the gross profit rate in the low-27% range, versus 25.8% in 2006 and 28.7% in 2005. It targets about 28% in fiscal 2008 and 29% in fiscal 2009, but those goals depend on a mix shift toward higher-margin home, apparel and seasonal categories and on lower inventory shrink. The company explicitly provides no assurance that these initiatives will succeed.

How strong is the balance sheet and can the company fund its plans?

Liquidity appears adequate. At February 2, 2007 the company held $189.3M of cash and equivalents and had no borrowings under its $400M amended revolving credit facility, which matures in June 2011. Operating cash flow was $405.4M. The company's $200M 8 5/8% notes are due June 2010. Management expects 2007 capital spending of $180-200M to be funded from operating cash flow and the revolver, and it stated that existing resources are sufficient for foreseeable needs.

What does the pending KKR buyout mean for shareholders?

Under the March 11, 2007 merger agreement, each common share would be converted into $22.00 in cash, with restricted stock and options accelerating. The deal is not subject to a financing condition but requires shareholder approval and regulatory clearance. If it fails, the company may owe a termination fee of up to $225M, and the stock price could decline. Seven putative class actions claim the price is inadequate and the process unfair, seeking to enjoin the transaction.

What legal or operational risks could weigh on results?

The company faces several collective or class wage-and-hour suits covering store managers and assistant managers under the FLSA and state laws, plus a sex-discrimination pay suit (Calvert). In March 2007 a nationwide store manager class was conditionally certified in Richter, and the company could face material liability if it loses. Additional risks include an EPA proposed penalty of about $0.8M over Krazy String, ongoing exposure from self-insurance reserves, and the operational execution of store closings and inventory clearance.

DG 10-K FY2007 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 29, 2007. Cited figures are marked; the original filing is the authoritative source.

Dollar General's 10-K for fiscal 2006 (ended February 2, 2007) shows a sharp earnings deterioration driven by a deliberate strategic reset.

Net sales rose 6.8% to $9.17 billion^a and same-store sales increased 3.3%, but net income fell 60.6% to $137.9 million, or $0.44 per diluted share, versus $1.08 in 2005. The gross profit rate dropped 289 basis points to 25.8%, largely because of $279.1 million in markdowns at cost tied to the decision to abandon the packaway inventory model and clear out seasonal, home and apparel merchandise. Operating margin compressed to 2.7% from 6.5%, and return on average equity fell to 8.0% from 20.9%.

Management is guiding to a low-27% gross margin in fiscal 2007, with recovery targets of roughly 28% in 2008 and 29% in 2009. Balance sheet and cash flow remain sound. Cash and equivalents were $189.3 million^b, inventories were $1.43 billion, and there were no borrowings under the $400 million revolver.

Operating cash flow was $405.4 million^c, and the company returned capital through $79.9 million of buybacks and $62.5 million of dividends. The company plans to close about 400 underperforming stores by the end of fiscal 2007, open about 300 new stores, and remodel or relocate about 300 more. Capital expenditures are projected at $180-200 million for 2007.

The filing also discloses a pending $22.00^d-per-share all-cash take-private by Kohlberg Kravis Roberts & Co. (signed March 11, 2007), which investors should weigh against the stock's standalone outlook. The agreement carries a termination fee of up to $225 million, and seven shareholder class actions challenging the price have been filed. Several wage-and-hour collective actions covering store managers also remain pending and could carry material exposure.

02—Key points

Key Highlights

Net income fell 60.6% to $137.9M ($0.44 diluted EPS) from $350.2M ($1.08) as the company absorbed strategic-initiative costs.
Gross profit rate declined 289 bps to 25.8%, driven by $279.1M of markdowns at cost in 2006, including $179.9M in Q4.
Net sales grew 6.8% to $9.17B, with same-store sales up 3.3%, though the 2005 comparison included a 53rd week worth about $162.9M.
Operating margin fell to 2.7% from 6.5%; ROE dropped to 8.0% from 20.9%.
Management guides to a gross margin in the low-27% range for fiscal 2007, rising toward 28% in 2008 and 29% in 2009.
Plans to close about 400 underperforming stores by end-2007 (128 already closed in 2006), open about 300 new stores, and remodel or relocate about 300.
Strong liquidity: $189.3M cash, undrawn $400M revolver, $405.4M operating cash flow, and a $500M buyback authorization.
Pending $22.00/share cash merger with KKR-affiliated buyers; up to $225M termination fee and seven shareholder suits pending.

03—Questions

Frequently Asked Questions

Why did Dollar General's profitability fall so sharply in fiscal 2006?
The decline came mainly from strategic initiatives launched in Q4 2006. The company discontinued its traditional packaway inventory model and sold through excess seasonal, home and apparel merchandise with heavy markdowns, totaling $279.1M at cost in 2006 versus $106.5M in 2005. It also recorded a $70.2M lower-of-cost-or-market inventory charge and SG&A charges tied to closing about 400 stores. Higher advertising, promotional spending, and executive compensation added to the pressure, partly offset by $13.0M of Hurricane Katrina insurance proceeds.
Is the margin pressure expected to be temporary?
Management says the markdown-driven pressure should persist through 2007, with the gross profit rate in the low-27% range, versus 25.8% in 2006 and 28.7% in 2005. It targets about 28% in fiscal 2008 and 29% in fiscal 2009, but those goals depend on a mix shift toward higher-margin home, apparel and seasonal categories and on lower inventory shrink. The company explicitly provides no assurance that these initiatives will succeed.
How strong is the balance sheet and can the company fund its plans?
Liquidity appears adequate. At February 2, 2007 the company held $189.3M of cash and equivalents and had no borrowings under its $400M amended revolving credit facility, which matures in June 2011. Operating cash flow was $405.4M. The company's $200M 8 5/8% notes are due June 2010. Management expects 2007 capital spending of $180-200M to be funded from operating cash flow and the revolver, and it stated that existing resources are sufficient for foreseeable needs.
What does the pending KKR buyout mean for shareholders?
Under the March 11, 2007 merger agreement, each common share would be converted into $22.00 in cash, with restricted stock and options accelerating. The deal is not subject to a financing condition but requires shareholder approval and regulatory clearance. If it fails, the company may owe a termination fee of up to $225M, and the stock price could decline. Seven putative class actions claim the price is inadequate and the process unfair, seeking to enjoin the transaction.
What legal or operational risks could weigh on results?
The company faces several collective or class wage-and-hour suits covering store managers and assistant managers under the FLSA and state laws, plus a sex-discrimination pay suit (Calvert). In March 2007 a nationwide store manager class was conditionally certified in Richter, and the company could face material liability if it loses. Additional risks include an EPA proposed penalty of about $0.8M over Krazy String, ongoing exposure from self-insurance reserves, and the operational execution of store closings and inventory clearance.

04—Continue

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